Equity income: home is where the heart is?

In September, US giants McDonald’s and Microsoft increased their dividend payments by 15% and 10% respectively.

At the same time, part state-owned UK bank Lloyds was locked in talks with the Financial Services Authority seeking permission to resume its dividend. The payment has been withheld since the height of the credit crunch in 2008, when regulators turned stringent and ordered stricken lenders to bolster their capital positions.

Banks used to be a staple of UK equity income funds before the financial crisis swept away this source and subsequently exposed there was a lack of diversity in the domestic market.

This was exacerbated by the crisis at BP, another income bellwether, forced to suspend its dividend in the summer of 2010 following the Deepwater Horizon spill.

Throw in fears about increased regulation in the banking and utilities sectors and it is hard to make a case for the once-dependable UK equity income market, especially in the face of some maturing global competition.

Too few names

Thurleigh chief investment officer Charles MacKinnon (pictured) outlines the issue: ‘The problem we are facing today is that there are many fewer high-dividend paying UK-based equities and this means there is too much concentration on a few names,’ he says.

‘This was shown very clearly when the disaster in the Gulf of Mexico forced BP to cut its dividend, which constituted a significant percentage of the dividend flow from the FTSE.’

According to MacKinnon, global funds, in contrast, have a much broader base of high-quality companies from which to pick. ‘They have not received the distribution and attention they merit, mostly as people are overly scared about the currency exposure,’ he adds.

‘Also, they are not always run by high street names and so intermediaries are less familiar. The real advantage of owning a global income fund is that you have a broader currency base and are less exposed to idiosyncratic risk of one company having a problem.’

Research from Société Générale Cross Asset Management highlights the concentration risk in the UK, with 10 stocks headed by Royal Dutch Shell, Vodafone and HSBC contributing more than 60% of the market’s total dividend.

A number of groups have come to market with global income products to exploit both concentration concerns in the UK and excitement about the growing overseas opportunity.

The most recent of these was Kames Asset Management, which launched its global proposition into the retail market at the end of September.

‘The UK has a deserved reputation as a high-yielding equity market. But other markets are catching up as an increasing number of international companies pay dividends to shareholders,’ the asset manager said in a statement accompanying the launch.

Stuart Rhodes, manager of the £3.6 billion M&G Global Dividend fund, outlines just how compelling this international opportunity is.

‘Investors are missing out on many excellent opportunities if they restrict themselves to the UK – a strong dividend culture is not unique to the UK,’ Rhodes says.

‘The US, for example, has more than 90 companies that have consistently grown their dividend payments for over 25 years, a reflection of the strong dividend culture in this region.

‘It is law in Brazil that listed companies have to pay 25% of profit as dividends and there is a favourable tax environment for dividends in Australia, making these regions interesting for dividend investors.’

This threat from global completion is underlined by recent fund buying behaviour.

According the Investment Management Association, in the 12 months to the end of August, UK income funds experienced net inflows of £485 million, which was dwarfed by the £872 million enjoyed by their global competitors.

‘I find it strange UK income funds have remained so in vogue when there are an increasing number of high-quality global income products on offer now,’ Becket says.

‘It might well have something to do with the lack of lengthy track records in the global space or cunning marketing by the fund houses of UK income strategies. Many investors still feel most comfortable investing in the names in lights, such as [Invesco Perpetual’s] Neil Woodford and [Artemis’] Adrian Frost.’

Becket adds: ‘The opportunities for global income investors are obviously far greater than for those constrained to the UK, with excellent dividend yields on offer in Europe and the emerging markets.

‘Furthermore, even the low-yielding markets in the US and Japan have seen the light (and the outperformance of dividend stocks) and started to increase their dividends, in some cases aggressively.’

Yet it is not easy to dismiss the UK as an income market, especially given its rich history and the fact it is home to some of the top managers in this country.

Making a case for the UK

Those who run UK equity income funds make a strong case for the sector, backing their arguments by some meaty statistical evidence.

Tineke Frikkee, manager of the £2.3 billion Newton Higher Income fund, one of the sector’s stalwarts, acknowledges global income looks attractive but points out the MSCI World has been more volatile than the FTSE All-Share over the last eight to 10 years, with currency movements increasing the risk levels.

‘Dividends from UK equity income funds are mainly exposed to the dollar-sterling exchange rate as 45% of UK companies’ dividends are declared in dollars,’ Frikkee says.

‘Currency exposure for dividends from global equity income funds are likely to be more diverse, with possibly more emerging market currency exposure. This may make future dividend distribution patterns less predictable or protectable.’

Frikkee also lauds the sophistication of the UK, which puts it at a premium to the global market. ‘The dividend yield on UK equity income funds is likely to be higher than on global equity income funds because the FTSE All Share dividend yield [currently 3.6%] is higher than the FTSE World dividend yield [3.1%],’ she says.

‘The UK has the longest dividend culture of most major equity markets, which may well offer greater dividend stability going forward.’

‘Although we forecast UK earnings growth to be negative for 2012, we expect this to turn positive again in 2013. UK dividends are currently well covered at 2.3 times and we expect them to grow by up to 7.5% over the coming year (assuming a repeat of the Vodafone special dividend),’ Colwell says.

‘While heightened uncertainty over corporate growth prospects persists and companies are likely to be conservative when setting dividend policy, balance sheets remain strong, with high levels of cash and dividend cover levels that are still well above long-term averages.’

Piers Hillier, manager of the Kames Global Income fund, still considers the UK a core market despite the plethora of opportunities available to him.

‘After the US, the UK has the most companies, approximately 50, that have consecutively grown the dividend over the last 10 years,’ he says. ‘With that kind of persistency these stocks offer an attractive alternative to lower-yielding assets for investors with income needs.

‘Looking at the FTSE 100, less than 30% of revenues come from the UK, making it one of the most globally diverse primary stock markets in the world. This, combined with the discount to global equity markets, offers an attractive risk reward trade-off for those looking for global exposure at a reasonable price.’

This is why Bestinvest senior research analyst Ben Seager-Scott remains interested in the UK. ‘The UK stock market is not the same as the UK economy,’ he says. ‘Many UK companies operate globally and a significant portfolio of revenues for FTSE 100 companies come from overseas.

‘In this way, many UK equity income funds benefit from global developments rather than UK-specific factors. For example, pharmaceutical companies – a favourite for many UK equity income funds – are benefiting from growing demand for their products and services in the emerging markets.’

It is statistics and anecdotal evidence like this that makes it difficult to abandon a market that has been so rewarding over the years.

All in the mind

Ultimately, however, it could be simple human nature that ensures UK funds remain prominent features on investors’ buy lists.

Seager-Scott says: ‘I think the reason they [UK equity income funds] have remained – and will continue to remain – popular is that for most developed economies, the majority of investors are likely to exhibit a natural home bias when it comes to equities. I think part of this is for pure investment reasons, and some of it is psychology.

‘From an investment point of view, investing overseas introduces an additional risk factor in the form of currency to a portfolio. It also keeps the manager’s investment universe limited to a relatively manageable size – after all, it is easier to have a reasonable working knowledge of most of the income-yielding companies in the UK than in the whole world.

‘There may also be a psychological element, where investors naturally feel more comfortable investing in a fund where they are familiar with a number of the stocks, being UK companies, than those that are overseas.’

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